Businesses often meet their operational needs by building a workforce comprised of both employees and independent contractors. This is particularly common in the construction industry, where labour requirements, project durations, and specialist skills can vary considerably from one project to the next.
There is nothing inherently wrong with engaging workers who are independent contractors. However, legal and commercial risks can arise where a worker is classified as a contractor but performs work in a manner that is more consistent with employment. This is regarded as misclassification of workers but may also be sham contracting.
Does the incorrect classification of a worker automatically mean the business has engaged in sham contracting? Not necessarily. A business may incorrectly classify a worker because it misunderstood the nature of the relationship and reasonably believed the worker was genuinely engaged as a contractor. However, misclassification and sham contracting are closely connected, and are territories businesses should aim to avoid.
What is the difference between an employee and a contractor?
An employee generally works in, and as part of, an employer’s business. The employer engages the employee personally, directs their work, and provides employment benefits, such as paid leave and superannuation.
An independent contractor operates their own business and provides services to another business under a contract for services. Contractors commonly trade through an ABN, company, partnership, or trust, and generally retain greater control over how they perform the agreed work. They ordinarily bear commercial risk, invoice for their services, and do not receive employee entitlements (although superannuation may still be payable for some contractors).
Businesses can lawfully engage employees, contractors, or a combination of both. The key issue is ensuring that the terms of each engagement, and the way the parties work together, are consistent with the classification the business has chosen.
What is sham contracting?
Sham contracting occurs when a business tells a worker they are an independent contractor, when in reality they are an employee. This ‘sham’ is generally revealed in practice, where the worker works under the same conditions as an employee, but is told they are a contractor and is not paid employee entitlements.
A business may misclassify a worker deliberately to circumvent employment obligations. For example, a business might use a contracting arrangement to avoid paying the worker leave and superannuation, or to undermine other employee rights. Misclassification may also result from a genuine misunderstanding of the distinction between an employee and a contractor.
An incorrect classification does not automatically amount to sham contracting. A business that can demonstrate it reasonably believed the worker was genuinely engaged as an independent contractor may avoid liability for sham contracting.
Whether that belief was reasonable may depend on the steps the business took before and during the engagement. Relevant considerations may include whether the business assessed the proposed working arrangement, used an appropriately drafted contractor agreement, reviewed how the relationship operated in practice, and responded to changes that caused the worker’s role to become more like employment.
However, avoiding liability for sham contracting does not necessarily remove the consequences of misclassification. If the worker is found to be an employee, the business may still be required to back-pay employment entitlements that arose from the incorrect classification.
Determining whether sham contracting has occurred therefore involves two related questions:
- was the worker legally an employee despite being described as a contractor; and
- if the worker was an employee, can the business establish that it reasonably believed the worker was an independent contractor?
How is a worker’s status determined?
The first question is whether the worker is legally an employee or an independent contractor. The test for this determination comes from the Fair Work Act, which requires consideration of the real substance, practical reality, and true nature of the relationship.
The ‘whole relationship test’ considers factors that represent the totality of the relationship, including:
- the terms of the written contract;
- how the parties perform the contract in practice;
- the level of control the business exercises;
- whether the worker can perform work for other clients;
- who provides the tools and equipment;
- whether the worker can delegate or subcontract the work;
- how the worker receives payment;
- who bears the risk of poor or defective work;
- whether the worker is operating their own business or working in, and as part of, the business that engaged them;
- whether the worker generates goodwill for their own business; and
- whether the worker performs a specialist trade or service.
No single factor determines the worker’s status. The classification depends on an assessment of the relationship as a whole and a weighing up of the above factors.
The written agreement remains important, but the parties cannot rely on it where the relationship operates differently in practice. The agreement may provide a contractor with the right to control their hours, work for other clients, and delegate the work. But if the business instead requires fixed attendance, prevents outside work and represents the worker as a member of its own business, the day-to-day arrangement may be inconsistent with the contractual description and will carry greater weight in the classification.
Engagement through a company, trust, or partnership may also support a contracting relationship by creating separation between the individual performing the work and the business acquiring the services. However, the use of a separate entity will not be decisive if the relationship otherwise operates as that of employment.
Understand the totality of each worker relationship, and seek legal advice if you need help determining a worker’s status.
Why do construction arrangements carry particular risk?
The construction industry relies heavily on subcontracting to manage fluctuating workloads, labour costs and project requirements. That reliance can allow employment-style characteristics to creep into genuine contracting arrangements.
This risk increases where a business contracts directly with an individual for labour over a long period, particularly where there is no arm’s-length subcontracting entity between them. It also increases where independent contractors work alongside employees under substantially the same conditions.
For example, a contractor who initially supplied specialist services for a defined project may gradually begin working fixed hours, reporting to an internal manager, using company equipment, and filling an ongoing role. Without periodic review, the engagement may begin to operate differently from the arrangement set out in the contract, so much so that it embodies the characteristics of an employment relationship.
How can businesses reduce risk?
Before engaging a worker, the business should consider the nature of the work it requires. If the business needs to control the worker’s hours, methods, attendance, workload, and ongoing availability, employment may be the more appropriate model.
Where the business genuinely requires an independent contractor, the agreement should accurately document that relationship. The contractor agreement should address the contractor’s ability to work for others, accept or decline work, delegate services, provide equipment, issue invoices, maintain insurance, and bear responsibility for defective work.
The business should then ensure that managers and supervisors apply the contractor agreement in practice and do not manage contractors as though they were employees.
Businesses should review contractor arrangements periodically, particularly where:
- the engagement has continued longer than originally anticipated;
- the worker now performs an ongoing internal role;
- the worker provides services exclusively to the business;
- managers have started directing the worker’s hours and methods;
- the worker no longer exercises any real right to delegate; or
- the contractor and employees perform the same work under the same conditions.
The review should compare the written terms with the way the relationship operates day to day. Amending the contract alone will not address the risk if the business continues to treat the contractor as an employee.
The key takeaway
Incorrectly classifying an employee carries risks. Incorrect classification may be sham contracting unless the business has made a genuine and reasonable mistake about a relationship that includes features of both employment and contracting.
Misclassification of contractors can expose businesses to serious consequences. If the worker is legally an employee, the business may face claims for unpaid entitlements, superannuation, compensation, and other employment-related remedies. If the business cannot establish that it reasonably believed the worker was a contractor, the incorrect representation may also amount to sham contracting and attract penalties.
The safest approach is to look beyond the title used in the written agreement. Businesses should periodically examine their worker relationship as a whole and ensure that both the documentation and the way the arrangement operates in practice reflect the intended classification.
If you’re concerned about a sham contracting risk or need a second opinion on classifying your workers, please get in touch with our Employment Services team.
